Business sales: The art of maximising your earn-out
David Kilshaw, of KPMG, looks at the tax implications of selling your business
It’s fair to say there’s no one-size-fits-all approach to exiting a business tax-efficiently. You have to look at your individual tax status well in advance of the point of sale and then attempt to set a course to find your way through what for many owner-managers are murky waters.
The key to a tax efficient sale of a business is to take advice at every stage of the process. If advice is taken regularly, the fees will be repaid many times over by the tax savings. In contrast, if it is only taken at the time of the sale it may be too late. The consequence of seeking tax advice at the wrong time could cost you as much as 40% of the sale proceeds.
The importance of timing
Perhaps the best example of the importance of timing is the capital gains tax relief known as ‘taper relief’. This reduces your tax bill the longer an asset has been held. However, it is necessary to distinguish between business asset taper and non-business asset taper. The former offers you the opportunity of a 10% tax bill after two years of ownership; in contrast, non-business asset taper will only reduce the tax bill to 24% after 10 years.
Shareholders in many unquoted trading companies can be in line for the 10% tax rate on sale. However, what you or I regard as a trading company may not qualify as such in the eyes of the Inland Revenue. For example, if you owned a company which manufactured widgets you might expect an owner to pay a 10% tax bill on sale. If, however, the company had been extremely successful and surplus profits had accumulated within the company, the Revenue may regard it as an investment company. This could be the case, for example, if the cash, which is not used in the business, represented more than 20% of the company’s value.
If you do find your business with surplus cash, you have a handful of options. You can either pay yourself a dividend or a bonus, which will be subject to taxation at the standard rate, or invest the money in the business, which in turn could make it more attractive to prospective buyers and is often part of the ‘grooming’ process.
Why seek tax advice?
A visit to the tax adviser during the life of the company can result in remedial action or prior Inland Revenue clearance, to confirm that the tax bill will still be 10% on sale. However, if you leave it to the time of sale, it is normally too late to correct the position.
There are many other examples of why you need to think carefully well in advance of sale. For example, if you wish to emigrate from the United Kingdom to avoid tax, you will need to do so before you have entered into a contract to sell the shares. It is normally necessary to leave the UK for five complete tax years, although a shorter sojourn may be possible in countries that have appropriate tax treaties with the UK.
For Belgium you’d need to spend at least 12 months in the country as a ‘permanent’ resident. For countries without appropriate tax treaties with the UK, the idea is to find a country that doesn’t have a penal tax regime – as a number of European countries, for example, do.
Advisers can help you select a country that fits your personal, familial and commercial needs. It is clearly up to the individual to decide whether the cost and emotional upheaval is worth it and is likely to relate to the amount of money you get for your business and the consequent size of the earn-out at stake. Once again, it might be too late if tax advice is only sought once the deal has been negotiated.
The sale process
The tax bill is triggered when the contract is signed, not when the deal is completed. This can be important. For example, if the date of contract was changed from say 31 March 2005 to 6 April 2005, the date on which the capital gains tax bill is payable could be postponed by a considerable period – a nice cashflow advantage. Similarly, taper relief is calculated by reference to full years and again the timing of the deal can be critical.
You should also seek be keenly aware of the structure of the deal and be represented during negotiations. Selling a business can involve the sale of shares (normally preferable from the vendor’s viewpoint) or assets held by the company (which may afford tax advantages to the purchaser) and an adviser will be able to negotiate the most amenable terms.
This also applies to the form of the sale consideration. For example, many deals involve a so-called ‘earn-out’ element, whereby the vendor receives extra value linked to the performance of the business following the sale. Get your tax planning wrong, and the vendor may pay tax on money they never receive or pay income tax on the earnout element at 40% instead of capital gains tax. Get it right, however, and the earn-out need only be taxed when it is received – and at favourable rates.
For this reason, instead of cash many earn-outs will take the form of loan notes, which are equivalent to an IOU where the company pays you at a future date. Loan notes can be supported by tax clearance obtained in advance by the tax adviser and will enable you to defer tax until you cash them in, which in some cases could reduce it by 30%.
The Inland Revenue has 30 days to provide clearance, so this should always be factored into the deal. If the vendor stays with the business, the Inland Revenue may argue that the earn-out is in fact disguised salary and seek to subject it to PAYE. The Revenue has published guidelines on this issue and these should be taken into account when drafting the sale agreement.
At the time of the sale, the position of employees often arises for consideration. The owner may wish to make payments to key staff either as a ‘thank you’ or as an incentive to work under the new management. These payments will normally be taxable for the recipient, but if carefully structured a tax deduction can be obtained for them.
In many cases, there will also be share options to take into consideration. The question is, should options be rolled over to options in the purchaser or exercised in order to achieve the optimum treatment for option holders?
Once the deal has been done, the parties can concentrate on growing the business under its new ownership. Following completion, your tax adviser can help you with all the necessary filing (the sale must be returned to the Inland Revenue and there are special notification provisions for transactions with employees).
Finally, there are quite a number of options for the tax-efficient investment of sale proceeds, such as the recommendation of tax efficient investment wrappers. These include investing new shares in another unquoted trading company that qualifies for Enterprise Investment Scheme (EIS) relief, or re-investing in a business via a Venture Capital Trust (VCT). You may also qualify for re-investment relief if you start a new venture, which many cannot resist – even with the appealing prospect of months spent sipping cocktails on a beach in the Cayman Islands.
David Atkins is the founder and CEO of All New Video. He previously ran and sold ?3m-turnover video conferencing business VideoWeb to Nasdaqlisted Genesys Conferencing. The ?7m deal for a combination of cash and stock was completed in 1999, three years after setting up.
?I sold Videoweb for part cash, part stock. We got the stock at ?14 and it went to ?75. We couldn?t sell it all at that point and now the price is just half a euro. Fortunately though, we just missed the change in capital gains tax laws and having to go abroad for five years. I went abroad for a year to the Caymen Islands and found myself thinking, ?there?s only so many rum and Coke?s you can drink, what are we going to do now??. You start thinking about how you are going to re-invest some of the money and start other projects. It was great to get some cash out. There?s still some risk in the stock, but we?re better off than we were three years ago. I opted for re-investing in new companies via VCTs. After all, why should I pay a percentage to the government? You find yourself sucked back in, but hopefully with a little more security than you started with.?